skimming the cream?

[Gareth Keenan]

Hi, I was going over the 2009 exam today, and the solution my manual has for skimming the cream is

If an insurer notices a positive characteristic that is not used in their rating structures (or competitors,) the insurer can market to those with the positive characteristic and try to write more of them(skimming the cream). The insurer will then benefit from lower loss ratios and better profitability.

Now, can you only skim the cream if you do not underwrite to specific characteristics? I thought you could also skim the cream if you were able to reflect a key characteristic in your rating structures that your competitors missed. Then you could offer discounts to risks with the positive characteristic and/or surcharge risks without the positive characteristics to simultaneously attract the more profitable risks, and drive away the worse risk with higher prices.

What gives?

Regards,

Gareth Keenan

[gaddy]

If you offer the appropriate lower price to lower risk insureds, and corresponding higher price to higher risk insureds, you are indifferent between the two. That is, your profit will be about the same (ignoring volatility). Skimming the cream means you make more profit than you should otherwise because you see something your competitors don't. If that was the case, you could leave prices alone, or charge just a little bit less, and aggressively campaign to get those low-risk insureds.

[Vorian Atreides]

Actually, you could still differentiate the rates and still "skim the cream" . . .

Suppose that the indicated rel for the low risk insureds is 0.75 and the high risk rel is 1.30. Then implementing rates using 0.85 and 1.20, respectively, will lead to skimming the cream for this company (and adverse selection for the competitor) until competitors start differentiating their rates (or change their underwriting criteria).

Note that by using only underwriting (and marketing) to make this differentiation, the company can actually prolong the time that they can skim since underwriting guides are not publicly accessible documents (unlike rate filings).

[X Double Prime]

I'm getting the same impression G.K.

Even WM says that skimming the cream is when you don't reflect the risk differential in your rating but market aggressively to those risks. (WM p151)

That is if everyone else is charging the same rate for risk X, and you recognize that risk X has lower loss potential because of characteristic Z, you want to write this risk in abundance. Sure, you can lower the rate to attract more of Risk X, but in some cases Regulators won't let you. Maybe marketing is not as effective as rate decreases in terms of profit, but it will still generate more profit than your competitors who have not recognized it yet.

At least that's my understanding. You can disagree if you want.